from Latin America’s Moment and Latin America Studies Program

Breaking the Cycle

I published an article with my colleague Dora Beszterczey in the Winter 2011 issue of the Americas Quarterly on the impact of opportunities and jobs lost to insecurity and the disproportionate costs of violence borne by small businesses and entrepreneurs.

by Shannon K. O'Neil

January 28, 2011 9:59 am (EST)

Businesses on the Frontline

Just a few years ago, Ciudad Juárez was Mexico’s fastest growing city, burgeoning with new maquiladoras churning out auto and computer parts, medical supplies and consumer goods bound north. Universities, restaurants and real estate blossomed in the export economy’s wake. Yet in the last few years, Ciudad Juárez has become the most violent city in Mexico and, by many accounts, the world. The number of drug-related killings has climbed each year, and 2010 is set to break another bloody record. October alone recorded 352 drug-related killings, more than the annual toll in 2007.

Three years into Mexico’s war against the drug cartels, narco-violence has left big business still standing and foreign direct investment still flowing, even in places like Juárez. Large corporations quickly beefed up security and changed the daily rituals for many workers. For instance, in border towns, managers, engineers and other support staff often move to the United States, returning to Mexico for work each day. Instead, the devastating effects of the violence occur at the micro- and small-enterprise level.

Over 10,000 small businesses—four out of 10 firms—have closed their doors in Ciudad Juárez alone. The city’s official unemployment rate climbed from virtually zero to 20 percent in the last three years, swelling the ranks of sidewalk vendors and other informal jobs. With few economic options available, many of the unemployed also found work in the drug cartels and local gangs, accelerating the downward economic and violent spiral.

The Real Costs of Insecurity

Policymakers, academics and financial analysts wrangle over the supposed cost of violence—estimated to slice between 1.2 and 3 percentage points off Mexico’s gross domestic product. But these numbers do not get at the more intangible impact of opportunities and jobs lost to violence and insecurity—and the disproportionate cost to small businesses and entrepreneurs.

Rising violence and insecurity have placed a financial burden on Mexican firms of all sizes. For larger firms, this has meant increased spending on insurance, security equipment, armored cars, and the like, amounting, on average, to 3 percent of their operating expenses. However, for small businesses, such costly insurance measures are simply out of reach. Their owners are obvious targets for organized crime. They lack the political weight, access and lobbying power to solicit policymakers to address their concerns. They are also less able to afford the private security forces upon which so many large corporations now rely. Subsequent robbery and extortion payments take a larger share of their revenues.In this insecure climate, financing at local banks dries up as banks further ration access to credit for small businesses.

Even if available, the insecurity adds a “violence premium” on loans that small entrepreneurs can ill afford. These combined factors prevent small business owners from making productive investments that would allow their firms to grow and innovate. In many cases, the effects prove insurmountable, leading firms to stay small and informal, or to close shop altogether.

These individual decisions—and often tragedies—have an impact on broader communities and the national economy. In Mexico, micro and small enterprises employ 28 million people, or 50 percent of the workforce. By being forced to remain small and informal, these businesses fail to spur the creation of new jobs and other economic opportunities.

The recent economic downturn is only sweeping more workers into the informal ranks. In Mexico and elsewhere in Latin America, the lack of opportunities available to young people makes crime an attractive alternative. In Ciudad Juárez, the 80,000 ni-nis—youth neither in work nor at school—are offered 500 pesos ($40) for each stolen car and 1,000 pesos ($80) for an assassination.

As the cartels up the ante in Monterrey, Mexico’s industrial heart and one of its wealthiest cities, young people run murderous errands for a “salaried” 4,000 pesos ($320) a week. Throughout the region, the challenge of providing opportunities and legal employment for youth coming of age will only grow. Without solutions, violence will continue to escalate.

So Where Can Governments Start?

Strategies that support micro and small entrepreneurs should be a first step. A 2008 World Bank study on Mexico shows that small injections of cash into microenterprises generate very high returns to capital—between 20 and 30 percent, and even higher for those on the lower rungs of the income ladder.¹ Access to capital not only provides a legal income for microentrepreneurs, but can also spur growth and employment in their broader communities.

This is particularly important in marginalized areas, where cartel and gang recruitment is common. As Latin American governments struggle against rising violence, pilot programs in a few cities illuminate the importance and potential, as well as the real challenges, of incorporating economic policies into crime-fighting efforts. The growing evidence also suggests that government initiatives need to move beyond just loans for small businesses. Coordinating efforts to retake the streets, to facilitate economic endeavors, and to open up broader social opportunities are all important for lasting success. And all these take time.

An Integrated Model in Medellín

Medellín, Colombia’s second largest city, has been actively confronting violence for nearly 20 years with some success. In 1991, Medellín’s annual homicide rate was 381 per 100,000 inhabitants. By 2004, homicides had fallen to 57 per 100,000, and 26 in 2009—lower than Washington DC (34) or Baltimore (43).

Improving law enforcement was an important factor in this decline. A national strategy to take down kingpins and extradite the most notorious drug lords cleared the way for the Colombian military and local police to storm the most violent barrios of Medellín, eliminate local militias, and begin reintegrating gang members into society.

But also important for Medellín’s recovery was the creation of a strong partnership between political leaders, the private sector, universities, and NGOs dedicated to rebuilding the city’s frayed social fabric and promoting widespread economic opportunity and growth. These concerted and sustained efforts created the nation’s first business cluster, which now employs 40 percent of the city’s workforce and made the city the top exporter in the country. In six years it also reduced poverty from 50 percent to less than 40 percent.

Programs to support microentrepreneurship were an integral part of the wider peacebuilding strategy from the outset. Neighborhood small business centers, or Centros de Desarrollo Empresarial (CEDEZOs), opened in eight of Medellín’s poorest barrios. These centers offer computer training and courses in business, administration and management and serve as incubators of new businesses, assisting start-ups with the paperwork needed to enter the formal sector. The CEDEZOs also bring together local microentrepreneurs with established businesses from similar industries across the city—providing new mentors for small and budding entrepreneurs. Just as significantly, the CEDEZOs are a one-stop-shop for a network of 12 microfinance institutions that provide entrepreneurs with a range of credit options under one roof. One of those institutions, the government-funded Banco de las Oportunidades, dispersed over 50,000 loans over the last eight years to the bottom rung of Medellín’s aspiring entrepreneurs. This led to the creation of over 2,000 microenterprises, employing over 6,000 people.

As Medellín recovered public space and brought security to the barrios, it mobilized the private sector and civil society to support government efforts to integrate barrio residents into the rest of the city. Top architects and engineers designed library parks and cultural centers. Private schools took over poorly performing schools. The municipal government expanded the transportation system to link the commercial and industrial city center with the once-marginalized peripheral area, thus opening up new opportunities for independent workers and small businesses. When a new cable car stop was established in the barrio of Santo Domingo Savia, in the northeast of the city, commerce in the area boomed as family stores, restaurants and banks opened.

Despite the dampening effect of these efforts on crime and unemployment, a resurgence in violence in some of Medellín’s barrios last year took the city by surprise. Many local observers blamed the intensified competition among regrouped local gangs and successor paramilitary groups, as well as persistent poverty and inequality. Another factor may have been the economic recession, which reversed several years of growth. The textile industry alone shed 10,000 jobs. Nevertheless, even though armed gangs have resurfaced across Medellín, the alternatives offered by coordinated programs have blunted the escalation of violence. The number of microloans awarded by the 14 banks in the microcredit network increased. Between February and August of this year, Banco de las Oportunidades disbursed over 360 loans in Comuna 1 alone, where Santo Domingo is located. In this way, the new businesses encouraged by the CEDEZOs have helped to create a buffer against the rising tide of unemployment.

From Favela to Barrio?

Rio de Janeiro’s efforts to tackle crime are more recent, and they lack the integrated approach that brought the government, private sector, NGOs, and universities in Medellín together. After years of escalating violence and crime spilling out of its over 1,000 favelas, Rio embarked on a more holistic approach to fighting crime in 2008.

Community-based Unidades de Polícia Pacificadora (UPPs) combine community trust-building—through the use of street patrols and civic work, such as teaching English, martial arts or music to youth—with more traditional anti-gang efforts. The establishment of local health clinics and improved public transportation also figure in the campaign. In the once-notorious favela of Cidade de Deus, one of the eight favelas where UPPs have been operating so far, there has been only one murder this year—down from 34 in 2008. These combined small steps are having a ripple effect on the Rio’s homicide rate, down 20 percent in the first six months of 2010.

Jobs, however, have been slower to arrive. Building on the initial momentum, the city launched programs to integrate favela microentrepreneurs into the city’s broader commercial fabric. The city established partnerships with NGOs to offer favela residents computer training and courses in business administration and management. The National Industrial Training Service (Serviço Nacional de Aprendizagem Industrial, or SENAI) now certifies painters, carpenters and repair workers—hoping to improve their access to the broader service market. Another agency announced a pilot project in Cidade de Deus to link favela entrepreneurs to municipal services, such as the provision of school lunches.

These efforts complement the ambitious Empresa Bacana program, which aims to bring informal businesses into the formal economy. Over a weekend in August, officials registered 220 informal businesses in Cidade de Deus, just under 10 percent of all businesses in that favela. To do so, the city reduced red tape by streamlining the procedures required to register a business (formerly involving over 40 separate forms) and allowing entrepreneurs without a legally recognized address (common in the illegal hillside settlements) to register through the nearest formal entrepreneur or community association. At a monthly cost of 60 reais ($35), businesses gain a legal license, allowing them not only to reach a larger market beyond the boundaries of the favela, but also increase their bargaining power with commercial wholesalers who often refuse to supply or charge inflated prices to informal businesses. Perhaps more important, the program represents a first step in giving these businesses access to commercial credit.

While a move in the right direction, these newly formalized businesses in Cidade de Deus are only a drop in the bucket. Broader opportunities remain elusive for many of these poor urban communities and their aspiring entrepreneurs. While Medellín’s CEDEZOs show that lenders with a deep understanding of poor residents’ needs can make microlending profitable, this type of encompassing initiative hasn’t yet spread within Rio’s favelas. Only one commercial bank operates a single branch in the over one thousand favelas in Rio, despite a potential customer base of over 300,000 households. Federal laws mandating that banks engage in microlending are not working. Many banks prefer to pay the penalties rather than devote the required 2 percent of their cash deposits to microcredit.

Instead, the government has left it up to a handful of NGOs to lead the way, without public coordination or oversight. VivaCred is one example. A pioneering institution that opened its first office in one of the largest favelas, Rocinha, in 1997, VivaCred today operates in six of Rio’s favelas. Thanks to a partnership with Brazil’s largest microfinance institution, CrediAmigo (operated by Banco do Nordeste do Brasil), VivaCred has brought CrediAmigo’s cheaper credits (lowering interest rates from 3.9 percent to 1.2 percent) and broader product range (including group credit with easier guarantees) to the favelas. Today, VivaCred is able to profitably administer some 4,500 loans annually to Rio’s favela residents.

While impressive, this still leaves most of Rio’s 1 million favela residents without access or opportunity. To really turn the tide for budding entrepreneurs and those trying to make a go of a new business in marginalized communities, a well-coordinated and integrated effort led by the city and the state government will be needed, building on the expertise of NGOs working in these areas and a strong commitment from the private sector.

Marketing Peace

In Ciudad Juárez, the Mexican government, with U.S. assistance, is refocusing its security strategy. The army presence is receding, replaced by federal and local police. Policymakers are intent on engaging citizens to take back the streets. For Juárez and urban centers struggling with violence, the lessons of Rio and Medellín provide starting points and cautious optimism.

They also point to the vital importance of economic initiatives alongside the more obvious law enforcement and judicial reforms. Expanding credit—particularly to micro and small enterprise—is a first crucial step. Although the region has a solid and highly profitable financial system, access to capital is surprisingly limited.

In Mexico, nearly 90 percent of the country’s 5-million-plus businesses operate without any credit. Most of the remaining 10 percent depend on loans from families and other businesses, not from financial institutions. Across Latin America, total private sector credit averages just 31 percent of GDP—less than half the figure for Western Europe, the U.S. and East Asia.

The lack of credit represents a significant barrier not just to furthering GDP growth but to improving regional security. Policymakers will need to encourage banks to lend more broadly, and they must urge microfinance institutions—who have been accustomed to working with rural clients—to better cater to urban clients, whose project and financing needs differ.

But this still won’t be enough.

Successfully scaling up the micro and often informal businesses that fuel the economy to small- and medium-sized legal entities that can become more powerful engines of growth and job creation will continue to be a primary economic challenge. This is made only more difficult by today’s escalating violence. Yet without this shift to fill the “missing middle,” Latin American nations will likely remain trapped in today’s vicious and violent circle. Medellín’s and Colombia’s experience more broadly offer important lessons. Without integrated economic, social and political programs, law enforcement campaigns and institutional reforms will not halt the violence. Another vital lesson is that Latin America’s economic elites must be a part of the solution. In Colombia, former President Álvaro Uribe, shortly after being inaugurated, levied a wealth tax on the country’s elites both to provide the finances necessary to step up the country’s security efforts and to symbolically demonstrate the collective responsibility to bring an end to its national trauma.

Similar efforts to establish a national commitment to address insecurity have yet to be replicated elsewhere in the region. Instead, too few among the economic elite have raised their voices to help turn the tide of violence. Until these leaders use their money and influence to build stronger governments and broader opportunities instead of higher walls, the region will continue to be plagued by insecurity. Establishing the conditions that will allow micro and small businesses to open and grow is an essential first step toward breaking that cycle and providing a long-term path out of violence.

Recommendations to increase urban micro- and small-business lending

Latin America’s solid financial system and strong economic growth, and the growing interest in the region among international financial institutions and investors, provide a promising climate for widening access to credit. Here are three steps that regional governments and institutions can take to help fuel the process:

1) Catalyzing finance for underserved urban clients

To increase micro lending, Latin American governments and international financial institutions can begin by offering funds to local banks to help them share lending risks, with a priority on underserved urban areas. Next, they should encourage innovative schemes to leverage further capital for microfinance institutions. For example, linking remittances to microlending would channel these funds into formal activities and promote productive investments while lowering costs for clients who frequently use both services. Governments should also do more to attract international investors to access local capital markets through Microfinance Investment Vehicles. Last year, the region received $37 million in such investments—a good start but still small in a region where microfinance portfolios make up over $12 billion in annual lending.

2) Building institutions to scale up long-term financing for development

To help microenterprises grow into small- and medium-sized enterprises (SMEs), governments should create departments and loan programs specifically targeted toward financing SME development—today largely nonexistent across the region. Since SMEs seek investments that are often too big to benefit from microfinance products yet too small to attract the interest of commercial banks or investors, greater government coordination is required both to evaluate and mitigate risk—and also generate the long-term, low-cost, fixed-rate capital currently lacking for these firms.

Facing these constraints, the role of international investors could be particularly powerful in the short term while domestic institutions are built up to cater to their needs. Involving the private sector and NGOs to build a pipeline of investment prospects for international investors and secure funding for SMEs would be the first step to link them to global investor networks. In November 2010, the G-20 SME Finance Challenge drew international attention to the importance of investing in SMEs at its meeting in Seoul. Latin American governments now should capitalize on the new interest from potential investors and incorporate the innovative ideas being developed globally to inject additional capital into SMEs.

3) Reaching non-established clients

In the short term, governments can seek the help of regional development banks and organizations such as the Inter-American Development Bank to train local banks on how to evaluate the creditworthiness of clients when they lack collateral and credit history.

In the longer term, governments should support the establishment of credit bureaus and other institutions to provide the data necessary for lenders to make decisions about credit offerings, and enable them to share data on borrowers’ loan histories.